5/13/2009 @ 4:00PM

Excerpt: 'A Failure of Capitalism'

The world’s banking system collapsed last fall, was placed on life support at a cost of some trillions of dollars, and remains comatose. We may be too close to the event to grasp its enormity. A vocabulary rich only in euphemisms calls what has happened to the economy a “recession.” We are well beyond that. We are in the midst of the biggest economic crisis since the Great Depression of the 1930s.

It began as a recession–that is true–in December 2007, though it was not so gentle a downturn that it should have taken almost a year for economists to agree that a recession had begun then.(Economists have become a lagging indicator of our economic troubles.)

The recession had been triggered by a sharp nationwide drop in housing prices the previous summer that had caused the market in “subprime”–very risky–mortgage loans to collapse. Housing prices had been bid up to unsustainable heights in the early 2000s. When the market decided that houses were no longer such a super investment, many people who were over-mortgaged relative to the value of their houses defaulted, and either abandoned their houses or were forced out by foreclosures.

The result was a glut of unsold houses and a drastic reduction in the amount of home building, as well as a great many nonperforming mortgages. Two mortgage hedge funds owned by the investment bank Bear Stearns went broke in the summer of 2007, along with American Home Mortgage Corporation and three investment funds owned by the French bank
BNP Paribas
. Countrywide Financial, the nation’s largest mortgage lender, narrowly averted bankruptcy.

The recession was overtaken by a financial crisis in March 2008, when Bear Stearns itself collapsed. The crisis became acute in mid-September, when the bankruptcy of
Lehman Brothers
, the distress sale of Merrill Lynch, the near collapse and ensuing government takeover of
Fannie Mae
and
Freddie Mac
(giant buyers and insurers of residential mortgages), and the bailout of
American International Group
, the nation’s largest insurance company, triggered a sharp drop in the stock market and a worldwide credit freeze. Frantic efforts by the Federal Reserve, the Treasury Department and Congress to save the financial system ensued.

These efforts culminated in early October when Congress enacted a $700 billion bailout of the banking industry (TARP–the Troubled Asset Relief Program). But the bailout could not prevent the further deepening of the recession. By the end of 2008–with the Detroit automakers on the verge of bankruptcy and economic activity everywhere declining sharply; with the Dow Jones Industrial Average having declined to 8,800 (at this writing–Feb. 2, 2009–it is down to 7,900) from 14,000 in October 2007 and from 11,100 as recently as Sept. 26; and with the Federal Reserve making desperate efforts to prevent a deflation–the recession was beginning to be seen as the first U.S. depression since the Great Depression of the 1930s.

The word itself is taboo in respectable circles, reflecting a kind of magical thinking: If we don’t call the economic crisis a “depression,” it can’t be one. But no one who has lived through the modest downturns in the American economy of recent decades could think them comparable to the present situation. The actions that the government has taken and plans to take bespeak fear that without radical measures of the kind that were or perhaps should have been taken during the Great Depression, we could find ourselves in almost as dire a predicament. It is the gravity of the economic downturn, the radicalism of the government’s responses and the pervading sense of crisis that mark what the economy is going through as a depression.

There is no widely agreed definition of the word, but I would define it as a steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and, among the political and economic elites, a sense of crisis that evokes extremely costly efforts at remediation.

It is too early to tell how protracted the downturn will be, and I recognize that protraction, so notable a feature of the Great Depression (especially in the U.S.), is a common marker for depressions. But it is expected to exceed in length every recession of the last half-century. Not that we are likely to see a 34% drop in output or an unemployment rate of 24%, as in the depth of the Great Depression. But there is semantic space between a “Great Depression” and a mere recession, especially if, as may well happen in the present instance, a “successful” effort to avoid a repetition of the Great Depression will impose enormous long-term costs on the economy.

The cost of a depression is not just the loss of output and employment before recovery begins, it is also the cost of the recovery, including such aftershock costs as inflation. There may be political costs as well. At this writing, the federal government, in a desperate effort to speed the recovery, has spent or committed to spend (I include the stimulus package now wending its way through Congress, as it seems certain to be enacted) $7.2 trillion ($5.2 trillion by the Federal Reserve, $2 trillion by the Treasury Department) and has guaranteed another $2 trillion in loans and deposits. We are facing the certainty of a huge increase in the national debt and the possibility of a future inflation rate so high that, as in the early 1980s, the Federal Reserve will have to engineer a severe recession (by affecting a sudden sharp increase in interest rates) in order to restore price stability. Such a recession would be an aftershock, and hence a cost, of the present crisis.

The aftershock would be all the greater if, at the same time that interest rates were rising, the government was raising taxes in order to trim an astronomical national debt. And suppose that to reduce the pain of a post-depression recession the Federal Reserve restarted the boom-and-bust cycle by forcing down interest rates. In short, even if the current downturn is arrested within months, the extraordinary measures that the government is taking to arrest it will cause profound economic problems for years.

Some conservatives believe that the depression is the result of unwise government policies. I believe it is a market failure. The government’s myopia, passivity and blunders played a critical role in allowing the recession to balloon into a depression, and so have several fortuitous factors. But without any government regulation of the financial industry, the economy would still, in all likelihood, be in a depression. We are learning from it that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails. The movement to deregulate the financial industry went too far by exaggerating the resilience–the self-healing powers–of laissez-faire capitalism.

To understand the economic crisis and draw the appropriate lessons while it is still unfolding will require our close attention to the following questions: What is this depression exactly? A mere liquidity crisis? A solvency crisis? Something else? And what precipitated it? What are the underlying causes? Why was it not anticipated? How well is the government responding to it? Is the depression unalloyed grief, or may it have some redemptive political or economic consequences–the silver lining that every self-respecting cloud should have? What can we learn from it about capitalism, government and the economics profession? What can be done to head off future depressions? What individuals or institutions are most culpable for having failed to foresee and avert the depression? What is its principal political lesson?

I organize my discussion around these questions. The media’s coverage of the crisis has been extensive, lively, often insightful and even riveting, though now it’s turning silly, with ignorant denunciations of “Wall Street” for greed and extravagance. (What did reporters think businessmen were like?) The sheer volume of that coverage is daunting, however, and much of it is anecdotal, ephemeral or both. There are books and articles galore, both journalistic and academic, about depressions in general and even about this depression.

But many of the writings are by authors with an ax to grind, or are too technical for non-specialists to understand, or are months behind the curve, or assume too much prior knowledge of the financial system (are too “insider-ish”), or, at the other extreme, are superficial. There is a need for a concise, constructive, jargon- and acronym-free, nontechnical, unsensational, light-on-anecdote, analytical examination of the major facets of the biggest U.S. economic disaster in my lifetime and that of most people living today. That is the need this book tries to fill.

My focus is on the course, causes and offered cures of the depression. But I also emphasize some points that have received relatively little coverage in other accounts: the depression’s political dimensions, the disappointing performance of the economics profession in regard to anticipating and providing guidance to responding to the depression, how ideology can distort economic policy, the inherent limitations of depression economics, how the self-interested decisions of rational businessmen and consumers can give rise to a depression (so there is no need to look for psychological explanations), and how the failure of officials and economists to anticipate the financial crisis and prevent its ripening into a depression echoes the failures of other officials and other professionals to anticipate and prevent other catastrophic events, like the Pearl Harbor or 9/11 attacks or the devastation of New Orleans by Hurricane Katrina. (In discussing these analogies I shall be drawing on my previous work on catastrophe and on intelligence failures. See my books Catastrophe: Risk and Response (2004) and Preventing Surprise Attacks: Intelligence Reform in the Wake of 9/11 (2005).)

I have tried to be simple without being simplistic-to write for generalists but also to suggest points that may interest specialists. I have eschewed the usual scholarly apparatus of footnotes and citations, though I list some further readings at the end of the book for those who want to read more widely in a fascinating and timely subject. I have been assiduous in suppressing extraneous detail; the book is a high-altitude survey and, since I am not a macroeconomist, reflects an outsider’s perspective–but there can be value in such a perspective.

By way of simplification, I do not distinguish between the overlapping governing bodies of the Federal Reserve System–the Board of Governors of the Federal Reserve System and the Federal Open Market Committee–but treat them as a single entity, the Federal Reserve. It is the Open Market Committee rather than the board that controls the supply of money, but the same person is chairman of both and dominates both, so for my purposes there is no need to distinguish between the two bodies. I also use the words “bank” and “banking” broadly, to encompass all financial intermediaries (firms whose business is to lend borrowed capital), because the lines that used to separate commercial banks from investment banks and other non-bank financial intermediaries have so blurred. When I want to speak about banks in a narrow sense, but the context does not indicate that, I use the term “commercial bank.”

The first five chapters describe how and why the economy has gotten itself into such a fix, what the government is trying to do to get the economy out of it, and how likely it is to succeed. The last six chapters focus primarily on the lessons that can be learned from the debacle and from the efforts to avoid or mitigate it–lessons that may help us avoid the next depression.

Some might think it premature to write about a depression before it ends and, indeed, before it has reached bottom. But when it ends, hindsight will rewrite history. With the passage of the American Recovery and Reinvestment Act of 2009, expected within weeks, virtually all the imaginable weapons that can be used against a depression will have been deployed (though innumerable changes of course and emphasis can be expected), and it may take years to determine their efficacy and to experience any aftershocks of the depression, such as runaway inflation.

This is a good juncture at which to take stock, albeit tentatively, preliminarily, of a momentous economic event that is likely to affect America and the world in profound ways. Irving Fisher’s path-breaking essay on the Great Depression appeared in 1933, long before that depression ended, and John Maynard Keynes’ immensely influential General Theory of Employment, Interest and Money appeared in 1936, before the depression ended in the U.S.

But because I am writing in medias res, I have decided to create a blog (I will call it “The Posner Economic Crisis Blog”), in which I will blog weekly on the crisis, beginning a week after the publication of this book, in effect continually updating the book. Comments from readers will be welcomed and posted, and I will respond to as many of the most insightful or informative comments as my time permits.

This will not be an entirely new venture for me. The economist Gary Becker and I blog weekly on issues of economic policy (see “The Becker-Posner Blog”). We began blogging about the nascent crisis back in June of 2007; and while I did not then foresee a depression, I expressed concerns that events have shown were realistic. Anyone interested in my thinking before I realized we were headed for a depression should look up my blog entries of June 24, Aug. 19, and Dec. 23, 2007. I have incorporated here and there in the book some materials from my blog entries beginning in September 2008, when the financial crisis hit with full force.

I thank my co-blogger, Gary Becker, for fruitful discussions of a number of the issues that I cover in the book, and Laura Bishop, Ralph Dado, Justin Ellis, Anthony Henke and Michael Thorpe for their very helpful research assistance.

Friedman’s help with my project deserves a special acknowledgment. I also owe special thanks to Aronson, my editor at the Harvard University Press, for his encouragement and deft management of this project, as well as for many insightful comments. None of the above is responsible for the errors that remain.